It is never too early to start planning when it comes to a child's financial future. Parents and grandparents have a few options for saving for a child depending on how the money is ultimately used. 529 plans are used to pay for post-secondary education, while a child's trust can be put to any purpose.
In 1996, Section 529 of the Internal Revenue Code established a type of savings plan that parents could use to save for their child's college costs. A 529 plan is sponsored by the state, so the specific details of each plan vary from state to state. Plan holders are not limited to holding a 529 in their state of residence. The 529 plan can be held in the state the child is planning to attend college. Two types of 529 plans exist: a prepaid tuition plan and a savings plan. Prepaid tuition plans purchase credits at a specific school, while savings plans set the money aside for future use at any school.
Unlike a 529 plan, a child's trust does not need to be used to pay for college. The owner of the trust has the ability to limit how much money the child receives from the trust and when the money is distributed, but the child is usually free to do with it what he wants. Several types of trust funds are available, and trusts set up under Section 2503 of the Internal Revenue Code have different rules than revocable or irrevocable trusts, for example, which are geared more toward estate purposes. A 2503b trust requires that money be distributed to the minor every year, although that money can be placed in a separate savings account rather than spent. A child receives the contents of a 2503c trust when she turns 21, rather than receiving annual payments throughout her childhood.
The earnings of a 529 plan are federally tax-exempt, as long as they are used to pay for college or post-secondary education. The earnings may also be exempt from state taxes, depending on where you live and the state the plan is in. If the money in a 529 is not used to pay for school and related expenses, the earnings are subject to income tax and a 10 percent penalty. You can avoid the penalty by transferring the plan to another beneficiary to use for college if one student does not use all of the money to pay for school. If the student does not need the funds in the 529 because he received a scholarship, there is no penalty.
The money in a trust fund is subject to income tax. A trust fund is treated as a separate taxpayer by the IRS, meaning it has its own taxpayer identification. The earnings for the trust are not counted on a parent's or child's 1040 form, but instead on a 1041 form. If a child has a 2503(b) trust, she must pay income tax on money distributed to her or to her custodial account from the trust every year. Money contributed to a trust or to a 529 plan is eligible for the gift tax exclusion, up to $13,000 per year as of 2012.
The amount in a 529 plan and in a trust needs to be reported if a student applies for financial aid using the Free Application for Federal Student Aid. Beginning with the 2009 to 2010 school year, 529 plans are now counted as parent assets, not the dependent student's, due to the Higher Education Reconciliation Act of 2005. Assets owned by students are counted at a rate of 20 percent toward the family's expected contribution, while assets in the parent's name are counted at a rate of 5.64 percent at the time of publication. The U.S. Department of Education provides updated information on reporting assets on the FAFSA and instructions for completing the application each year.
- FinAid: Gift Taxes
- Saving for College: Does a 529 Plan Affect Financial Aid?
- Family Education: Setting Up a Trust Fund
- FinAid: Trust Funds and Financial Aid
- U.S. Securities and Exchange Commission: An Introduction to 529 Plans
- Saving for College: What is the Penalty on an Unused 520 Plan?
- IRS: Publication 950 Gift Tax
- IRS: Instructions for Form 1041
- FinAid: 2503(c) Minor's Trust
- Education: Saving for College in Trust Accounts: Paying Tax on Your Trust